Which statement best describes depreciation and its impact on financial statements?

Which statement best describes depreciation and its impact on financial statements?

• A. Depreciation increases cash flow in the period it is recorded.
• B. Depreciation has no effect on profits or taxes.
• C. Depreciation is the systematic allocation of a fixed asset’s cost over its useful life, affecting profits and tax deductions.
• D. Depreciation is a cash expense that reduces cash on hand.

Answer: (C)

Depreciation represents the systematic allocation of the cost of a long‑lived asset over the periods it helps generate revenue. This aligns the expense with the periods of use and follows the matching principle. It is a non‑cash expense, so recording it lowers reported profits in the period without any cash outflow at the same time. Because it reduces pretax income, it also lowers taxes payable, creating a tax shield that can improve cash flow indirectly over time. Depreciation thus affects both profits and taxes, even though no cash is spent when it’s recorded. That’s why describing depreciation as the systematic allocation of a fixed asset’s cost over its useful life, affecting profits and tax deductions, is the best explanation. The other statements misstate either the cash impact or the effect on profits and taxes.